Understanding Working Capital and Financial Ratios

Working capital calculation

Working capital = current operating assets - current operating liabilities

Working capital measurement

Working capital measures the amount of invested capital tied up (net investment in) in short-term, productive operating assets.

Purposes of working capital analysis

1) Short term liquidity assessment. 2) Understanding sources and uses of working capital. 3) Identify historical drivers and leading indicators of firm performance.

Positive net working capital implication

Positive NWC implies some level of liquidity in the short term (but doesn't take into account long-term liabilities).

Return on assets (ROA) calculation

Return on assets (ROA) = [Net income + interest expense (1 - tax rate) + minority interest) / Average Total Assets.

Meaning of ROA

ROA is designed to measure the after-tax rate of return being earned on all of the firm's assets (regardless of financing method or nature of assets).

Return on operating assets (ROOA) calculation

Return on assets (ROOAA) = [Net income + (net) interest expense (1 - tax rate) + minority interest) / Average Total Operating Assets.

Total Operating Assets definition

Total Operating Assets = Total Assets - Financial Assets.

Return on net operating assets (RNOA) calculation

Return on assets (RNOA) = [Net income + (net) interest expense (1 - tax rate) + minority interest) / Average Net Operating Assets.

Return on Equity calculation

Return on equity estimates accounting rate of return being earned by the providers of equity capital.

Current ratio calculation

Current Ratio = Current Assets / Current Liabilities.

Quick ratio calculation

Quick Ratio = (cash + mkt. securities + A/R) / current liabilities.

Cash ratio calculation

Cash Ratio = (cash + mkt. securities) / current liabilities.

Short-term coverage ratio calculation

Cash Flow from Operations / Average Current Liabilities.

Defensive Interval calculation

Defensive Interval = 365 * [(Cash + mkt. securities + A/R) / 'Projected Expenditures'].

LIFO vs FIFO measurement

LIFO better measures true COGs for each item sold.

Inventory analysis insights

Inventory analyses can be used to detect the impact of changes in demand, product mix effects, and inventory management.

Inventory turnover interpretation

Inventory turnover can be interpreted as a measure of how efficiently inventory is managed.

Inventory Turnover

Cost of Goods Sold / Average Inventory

How do you calculate A/R Turnover?

Net Credit Sales / Average Accounts Receivable. If you don't have credit sales, you might instead just use Net Sales. A change in AR in this case could indicate a change to customer mix (e.g., B2B -> B2C).

How do you calculate A/P Turnover?

Net Credit Purchases / Average Accounts Payable. If you don't have credit purchases, may need to use Total Purchases.

What can analysis of Accounts Payable uncover? (3 things)

1) Change in the ability of the firm to pay suppliers, 2) Change in terms of trade offered to the firm (intensity of trade credit used), 3) change in the firm's working capital management practices.

Inventory Holding Period

365 / Inventory Turnover.

A/R Collection Period

365 / Accounts Receivable Turnover.

A/P Payment Period

365 / Accounts Payable Turnover.

Ending Inventory Equation

Ending Inventory = Beginning Inventory + Purchases - COGS (+/- valuation adjustments). Purchases can be inferred, but is hard to see.

Operating Cycle

Operating Cycle = Inventory Holding Period + A/R Collection Period.

Net Trade Cycle

Operating Cycle - A/P Collection Period.

Asset Turnover

Net sales / Average Total Assets. The ratio measures how efficiently a company uses its assets to generate revenue.

Days Sales Outstanding (DSO)

DSO = (average accounts receivable / net revenue) * 365.

Impact of FIFO vs. LIFO on COGS

Using FIFO will understate COGS (cheap sold first), while LIFO will reflect current costs (expensive sold first). This is because with LIFO, COGS reflect the inputs purchased most recently.

Impact of FIFO vs. LIFO on Carrying Value of Inventory

With FIFO, inventory will be fair market value today, but can lead to forecasting distortion. With LIFO, carrying value of inventory will be understated.

LIFO Reserve Calculation

LIFOFIFO - LIFOLIFO.

Change in LIFO Reserve Calculation

COGSLIFO - COGSFIFO.

Benefits of LIFO over FIFO (4 benefits)

With LIFO, you get 1) Tax deferral via lower reported profits, because COGS are higher, 2) improved cash flow due to deferred taxes, 3) better 'cost-to-revenue' matching because LIFO charges current-period costs to COGS, and 4) hedging against inflation, because increases to input costs automatically suppress income.

What analytical adjustments do you make to get the benefits of both LIFO and FIFO?

Use FIFO numbers for balance sheet-related numbers and ratios and use LIFO numbers for income statement-related numbers and ratios.

How does FIFO cause forecasting distortion? (3 reasons)

1) FIFO puts the oldest & cheapest costs into COGS, so reported gross margin is artificially high when prices are rising. 2) On the balance sheet, ending inventory under FIFO is valued at the most recent (higher) costs, while COGs in the income statement is based on older, lower costs, 3) sudden margin compressions can be seen when prices continue to rise & company eventually 'runs through' its older layers. COGS spike & margins quickly drop.

Gross Margin Calculation for LIFO Accounting

GM = [sales - COGS (LIFO)] / Sales.

Working Capital Calculation for LIFO Accounting

WC

Current Operating Assets (FIFO) - Current Operating Liabilities

How do you calculate inventory Turnover under LIFO?

COGS (LIFO) / Average Inventory (FIFO) --> (Quantity sold * cost / unit) / (Avg. Inventory Units * Cost/unit)

What does it mean when the LIFO reserve declines?

When the LIFO reserve declines, it means you're liquidating older, lower-cost layers and recording an artificially low COGS under LIFO—which boosts reported gross margin.

Poor earnings quality features (3 features)

1) earnings fueled by one-time events are not as valuable as steady, persistent earnings streams.

2) Earnings that fail to convert to cash flows (in a timely manner) are less valuable.

3) earnings supported by suspicious accounting accruals or transactions lack inherent quality.

Sections of the statement of cash flows (3 sections)

1) Cash Flow from Operations: Cash-based measure of operating activity. Can be presented using direct or indirect method.

2) Cash flow from Investing Activities: Capital expenditures, short and long-term investment activity, divestitures of long-term assets.

3) Cash Flow from Financing Activities: Debt issuances and repayments, equity issuances and repurchases, dividend payments.

A firm experiencing a significant increase in cost of goods sold expense must have a corresponding increase in their inventory turnover ratio in a given fiscal period;

Answer: False.

Explanation: A rise in COGS alone doesn't guarantee faster inventory movement—inventory turnover also depends on beginning and ending inventory levels, so turnover can stay the same or even decline if inventory grows proportionally more than COGS.

ROA realization and profit margin

To maintain a constant ROA realization, an increase in the firm's profit margin implies a decrease in the total asset turnover ratio. Explanation: Since ROA = (Profit Margin) × (Asset Turnover), if profit margin goes up but ROA stays constant, asset turnover must fall proportionally to offset the margin gain.

What impact does a smaller amount of current LTD have on operating working capital?

No effect.

What impact does the conversion of the firm's trade payables into a two-year note payable have on operating working capital?

Operating working capital will increase, because reclassifying trade payables (a current liability) as a two‐year note (a noncurrent liability) reduces current liabilities, thereby raising net operating working capital.

What impact will a decrease in financial leverage have on the volatility of ROA?

No effect

What impact will an economic profit-based compensation scheme likely have on an executive's incentive to over-invest?

Answer: Decrease.

Explanation: An economic profit-based compensation scheme subtracts a charge for capital employed from NOPAT. This discourages low-return projects.

Economic profit valuation model benefits (3 benefits)

1 - Can be used for companies that are cashflow negative, yet generating meaningful economic profit (e.g., Amazon). 2 - Less sensitive to arbitrary selections around growth rate, discount / WACC, etc. 3 - Terminal value is reflective of predicted end state of the company, rather than assuming their growth rate will hold consistent at 5 or 7 years in the future.

How do you calculate YoY invested capital increases in an economic profit model?

If company does not pay out dividends, then you assume that the entirety of the profit a company makes is then invested back into the company.